You know you should have savings to achieve your goals and help you out in emergencies. But what you may not know, is how to make those savings really work for you. The secret is compound interest.
Most of us have heard of Warren Buffet. He is one of the wealthiest people in the world and is regarded as an extremely successful investor. Many reasons have been given for his success: from picking the right companies to invest in to living a modest lifestyle and not spending money on fast cars and lavish homes. While there is truth in all these factors, one of the biggest reasons for Buffet’s wealth is the power of compound interest.
You see, Mr Buffet first started saving and investing when he was about 10 years old. Today he is 92, meaning he had given his money more than 80 years to work really hard for him. Here is a statistic that explains it: in 2022, Buffet’s net worth was $84.5 billion (more money than most of us can even imagine). Of that, $84.2 billion was accumulated after his 50 th birthday. That means that in his first 40 years of saving and investing, he “only” made $300 million; more than $84 billion flowed in in the second 40 years – a big chunk of it due to compounding.
Let’s look at another example that makes more sense to us ordinary people. Tax-free savings
accounts (TFSAs) were introduced in South Africa eight years ago, in 2015. If you had invested the maximum annual amount every year since, you would have saved R257 000 by the end of February this year. Thanks to the power of compound interest, however, the balance in your TFSA account could have been R624 000, depending on where your money was invested (this calculation was done by the Ninety One investment platform). That means you would have made R367 000 without doing anything! By simply leaving your money in your TFSA and allowing it to earn interest on interest, you would have earned more than the actual amount you have saved. Now that’s making your money work for you!
Here’s another number that will amaze you. If you put the full annual amount you are allowed into your TFSA at the beginning of each tax year, instead of at the end, you could get an extra 10% after 15 years – simply because you gave your money more time to grow.
Now that you know that compound interest is an amazing thing, let’s take a moment to understand how it works.
When you put your money into a savings or investment account, you earn interest on the amount you put in. With compound interest, the interest you earn is added to your principal amount, which means you earn interest on your principal plus the interest you’ve already earned.
If, for example, you invest R1 000 with an annual interest rate of 5%, after the first year, you would receive R50 in interest, bringing your total investment to R1 050. In the second year, you would earn interest on R1 050, giving you an extra R52,50 (5% of R1 050). Your total investment would then be R1 102,50 and that’s the amount on which you would earn interest.
As you can see, with compound interest your money is working for you by earning interest on interest. The longer you leave your money in the account, the more it will grow.
Compound interest needs time to really work its magic, which explains why it is so important to start saving from a young age – and why it’s so important to have savings that you don’t use.